Demonstrators stand between protest banners underneath the euro sign in front of the European Central Bank in Frankfurt, central Germany, Monday, Oct. 17, 2011. Protestors gathered at many major European cities last Saturday to join in demonstrations against corporate greed and inequality and to support the US movement ' Occupy Wall Street'. About 150 protestors in Frankfurt remained at that place , some with tents. (Thomas Lohnes/Thomas Lohnes/Associated Press)

Demonstrators stand between protest banners underneath the euro sign in front of the European Central Bank in Frankfurt, central Germany, Monday, Oct. 17, 2011. Protestors gathered at many major European cities last Saturday to join in demonstrations against corporate greed and inequality and to support the US movement ' Occupy Wall Street'. About 150 protestors in Frankfurt remained at that place , some with tents.(Thomas Lohnes/Thomas Lohnes/Associated Press)

Voluntary or forced? The important word games of debt default
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Investors struggled with that question Thursday after European officials outlined plans that would see owners of Greek bonds take a 50 per cent loss on the face value of their holdings.

Banks, hedge funds and speculators betting on such a move had bought a net $3.7-billion (U.S.) of credit default swaps, a type of insurance, to protect themselves against the possibility that Greece would not be able to pay its debt.

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German Chancellor Angela Merkel (L) gestures as she gives a joint press conference with French President Nicolas Sarkozy as part of the European Council at the Justus Lipsius building, EU headquarters in Brussels on October 23, 2011.
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Market View

In theory, a CDS is supposed to pay off in the event of a default. In practice, however, determining what constitutes a default can be a contentious issue.

The International Swaps and Derivatives Association, an industry group that oversees the CDS market, says the Greek deal probably won’t trigger default clauses in CDS contracts because the 50 per cent “haircut” is voluntary.

That view is starting to roil the $25-trillion market for credit default swaps because it calls into question the fundamental reason for purchasing insurance against losses on bonds. If investors can no longer count on being able to hedge against the possibility of a loss, they may start demanding higher yields as compensation for increased risk.

“I would think [such a ruling by the ISDA]would be quite a negative for the market,” said Lawrence Chin, director of research at the Cundill division of Mackenzie Financial. “You could get hit on the debt, but you don’t get the insurance [payout]”

The European plan for how to handle Greek debt has raised so many questions for CDS holders that the ISDA prepared a special question-and-answer document in response.

“Based on what we know it appears from preliminary news reports that the bond restructuring is voluntary and not binding on all bondholders,” the ISDA said on its website Thursday. “As such, it does not appear to be likely that the restructuring will trigger payments under existing CDS contracts.”

But things can be confusing, even at the ISDA. In a version of the Q&A dated July 8, the ISDA asks, “Does it matter whether the event is ‘voluntary’ or ‘mandatory’ ”? Answer: “The CDS Definitions do not refer to a distinction between voluntary and mandatory events, though it does come up indirectly.”

Then there’s the matter of just how voluntary the latest agreement really is. Banks may have agreed to take a 50 per cent loss on their Greek debt holdings to avoid an even worse deal.

David Geen, general counsel for the ISDA, acknowledged in an interview on Bloomberg Television that there was likely some “coercion” of banks by European officials. “There’s been a lot of arm twisting,” he said, but asserted that while the deal may have been “borderline.” it still fell short of being a default.

The Determinations Committee of the ISDA will make a final decision on whether the Greek deal triggers CDS payouts “when the proposal is formally signed, and if a market participant requests a ruling from the DC,” the association said in its Q&A.

If investors lose confidence in CDS as a way to protect against losses on debt, they could cut down on their lending to highly indebted countries. Less investment could lead to slower economic growth, Steven Tananbaum, managing partner and chief investment officer at GoldenTree Asset Management, said at a conference in New York.

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